Echoes of a proper crisis

When I heard on the radio yesterday morning that a “famous currency trader” had warned that if Britain voted to leave the EU, Sterling would suffer a fate even worse than Black Wednesday in 1992, I did wonder how old this trader must be.  Almost everyone I knew who was trading anything back then has long since hung up their red braces for an easier life. I pondered a list of likely suspects while I waited for the story to come around but it turned out they were talking about none other than George Soros and, at 85, they don’t come much older than that.  Perhaps that’s why they felt they had to describe him as a famous trader rather than just come right out with it and say his name. Do they think the public have forgotten him?

Of course, the truth is that George Soros is better known as a long term investor, rather than a mere trader, and his experience of living through the exit of Sterling from the Exchange Rate Mechanism is worthy of note because, if nothing else, he netted a $1 billion profit and, in the process, coining the title of “The Man Who Broke the Bank of England”.

Putting aside Mr. Soros’s equity stakes in and around Europe and his heavy financial involvement in Ukraine, he raises an interesting point about how badly things can go wrong when they do.  In an investment era where markets are constrained as never before by the whims of central banks, it’s easy to forget how geopolitics, and the ill-considered actions of central banks, can spill over into markets with severe consequences.

We’re not a superstitious bunch here at TAM but a few of us attended an evening dinner in the Assembly Rooms in Bath last week and happened to be seated in the very room where the Bundesbank Council dropped the financial bomb on the UK Government back in September 1992 that put the UK on the road to exiting the Exchange Rate Mechanism (ERM), the infamous Black Wednesday.

Europe’s finance ministers and top bankers met in Bath and the then Chancellor of the Exchequer, Norman Lamont, was under pressure to cut a deal with the German Bundesbank to lower their own interest rates.

In the UK, homeowners were living with negative equity for the first time in history. Indeed, the expression, familiar today, originated in 1992. However, Germany was battling with the higher than expected costs of unification with East Germany and the resulting inflation.  Under the rules, a move higher in German interest rates to combat inflation should in theory have been matched by the Bank of England in order for Sterling to maintain its strong parity with the Deutschmark.

Lamont tried in vain to talk the Bundesbank Council out of raising rates but to no avail. As far as the Germans were concerned, they were compelled to act in the best interest of their own economy and were in no mood to negotiate.

The next day, the problems were compounded by the Italian government trying to prevent the collapse of their entire economy – for much the same reasons as the UK. The cost to the Bank of Italy in propping up the Italian Lira were crippling.  In the middle of this new crisis, the Germans finally offered to cut their interest rates provided Italy, Britain and others devalued their currencies.

John Major flatly refused the offer but the Italian Lira devalued by 7% immediately in response to a measly 0.25% cut in German interest rates. Due to a slip of the tongue in an interview, the President of the Bundesbank, hinted that the realignment of the Lira was not good enough and wanted Sterling to follow suit.  Heavy selling of Sterling ensued.  An emergency meeting of the UK government took place to decide what to do when London markets reopened but was adjourned in the small hours.

On the fourth day after the meeting in Bath, on 16th September 1992, Black Wednesday dawned but it was too late. There was huge selling of Sterling.  The Bank of England got to work spending their £1 billion fighting fund to buy Sterling in support.  The Treasury had thought it would be enough to last until the weekend but by lunchtime it was all gone.  The only thing left to the PM, John Major, was to propose raising interest rates dramatically from 10% to 12% to show political will, defend the pound and stabilise the market.  Cabinet members Heseltine, Hurd and Clarke all endorsed the plan to release the £19 billion of gold and foreign currency reserves to the cause.

Ken Clarke, thinking that it was game set and match to the UK Government, actually left the meeting to return to the Home Office.  But the policeman driving the car, who had been listening to the radio, told him that “It hasn’t worked, sir”.  It was true. Such was the selling pressure that even these reserves were being spent at a rate of £2 billion per hour and Ken was back at Admiralty House within half an hour (John Major’s temporary cabinet room having relocated due to the IRA mortar bombing of No.10 the previous year).

John Major announced that interest rates would rise to 15%. This was an extremely dangerous move because, given the effect on mortgage payments, it simply couldn’t be credible or sustainable.  Markets could not believe it.  If anything, it smacked of desperation – a sign of weakness, not of strength.  In a typically British scenario, Heseltine, Hurd and Clarke were sitting drinking tea in the afternoon and suddenly realised they had no idea what was going on because they had no TV or radio and went rummaging around The Admiralty looking for a wireless. When they finally tuned in, they realised the Bank of England had spent £15 billion defending the currency.  A late rumour went around that the Bundesbank was prepared to cut rates to help. But it wasn’t true. The game was up.  John Major decided there was no choice but to pull Sterling out of the ERM.

But no announcement was made to markets.  The only indication that something had changed was that chaotic dealing rooms across the City suddenly fell silent as the Bank of England ceased buying Sterling.  Markets closed, still with no announcement. The market was on its own and Sterling had lost 15% against the US dollar.

Today, Wednesday by the way, markets are relatively quiet.  On any other day, we would be all over Janet Yellen’s testimony to the Senate Banking Committee. That was business as usual but with the additional concern over Brexit thrown in.

Tomorrow could be another matter entirely.  There could be some big moves in reaction to the first exit polls. Friday is likely to be where the real action is. To get some idea of where things could go on the back of a Remain result, we could do worse than to look back to the beginning of the year when Remain looked nailed on at 9 to 1 with the bookies.  With today’s values in brackets, the FTSE 100 was 6,314 (6,225), Sterling $1.48 ($1.46) and the 10-year Gilt 1.96% (1.30%).

Bearing in mind the US S&P500 Index has done better than the FTSE 100 by 7% over one year, it’s not hard to imagine the FTSE getting comfortably over 6,500 and Sterling stronger over $1.50.  The Gilt yield will rise; its fortunes still caught between Fed rate hikes and Eurozone negative rates.

With markets clearly pricing in a far greater likelihood of Remain, these moves would not be so much life changing as more of a return to normality.

If it’s Brexit, then it’s going to be a very busy day.  Just make sure you know where you can get your hands on a radio.